Rewriting the Macroeconomists’ Playbook in the Wake of the Crisis

Before the global economic crisis, mainstream macroeconomists had largely converged on a framework for the conduct of macroeconomic policy. The framework was elegant, and conceptually simple. Caricaturing just a bit, it went like this:

The essential goal of monetary policy was low and stable inflation. The best way to achieve it was to follow an interest rate rule. If designed right, the rule was not only credible, but delivered stable inflation and ensured that output was as close as it could be to its potential.

This was achieved by setting the key policy rate that then affected the term structure of interest rates and asset prices, and then to aggregate demand. One could safely ignore most of the details of financial intermediation. Financial regulation was outside the macroeconomic policy framework.

On currencies, countries could set an inflation target and float, or instead choose a hard currency peg or join common currency areas. In general, in a world in which central banks followed inflation targeting, there was no particular reason to worry about the level of the exchange rate or the current account balance. Certainly, attempting to control exchange rates through capital controls was undesirable. And multilateral coordination was not required.

Fiscal policy had a limited role at best, at least in the short run. With the right use of monetary policy, it was not really needed. Automatic stabilizers, such as unemployment benefits, would kick in during downturns, but discretionary policy was more likely to be misused than used well. The focus had to be on the medium run, and on fiscal sustainability.

These were simple principles, and they seemed to work. From the early 1980s on, macroeconomic fluctuations were increasingly muted, and the period became known as the “Great Moderation”. Then the crisis came. If nothing else, it forces us to do a wholesale reexamination of those principles. Here are some ideas to guide the conversation:

Economic imbalances: Achieving stable inflation is good, but we can now see it does not guarantee stable output. Before the crisis, steady output growth and stable inflation hid growing imbalances in the composition of output and in the balance sheets of households, firms, and financial institutions, as well as growing misalignments of asset prices. These imbalances ended up being very costly. The question now is how best to address such imbalances. Should we think of macroeconomic policy as having three legs—monetary, fiscal, and financial—each with separate authorities? Or should we think of extending both the mandate and the set of tools of monetary policy to cover both output and financial stability? And, if so, what tools do we have and how do we use them?

Interest rates: Early in the crisis, central banks decreased policy rates, until they reached their lower bound––namely zero. From then on, interest rate policy could not be used to prop up aggregate demand, and central banks turned to both credit and quantitative easing. This raises many questions. First, would it have helped if nominal interest rates had been higher to start, giving more margin of maneuver to central banks? Put another way, should we revisit the low inflation targets, and the associated low average nominal interest rates, that central banks had adopted pre crisis? Second, are credit and quantitative easing policies just for exceptional times, or can they work and do they make sense in more tranquil times?

Fiscal policy: When interest rates reached the lower bound, fiscal policy came back to the fore. Going beyond automatic stabilizers, most countries adopted fiscal stimulus programs to increase aggregate demand, but debates about the size and even the sign of multipliers associated with different fiscal measures made clear how little work had been done on fiscal policy, and how much needed to be done. The large increase in debt since the beginning of the crisis (an increase which is overwhelmingly due to the loss of output and the implied loss in revenues rather than to the fiscal stimulus programs themselves) also raises many issues. Even though it will be a long time before debt levels are reduced sufficiently, what levels of public debt should countries aim for? Are old rules of thumb, such as trying to keep the debt to GDP ratio below 60 percent in advanced countries, still reliable?

Capital flows: The crisis triggered very large capital flows. Often, these flows had little to do with conditions in the country that they left, and more to do with the need by foreign financial institutions to repatriate funds in a hurry. More recently, capital has gone back to emerging market countries, sometimes with such force as to trigger complaints of ‘currency wars,’ leading to intense discussions about capital account management. How should countries react to large capital inflows? If they want to mute their effect for example, when should they build up reserves and when should they use capital controls? Should each country be left to do what it feels is best for itself, or should there be international rules of good behavior?

International monetary system: Talking about international rules of good behavior, the crisis raises both old and new questions about the international monetary system. Should benign neglect determine the coordination of monetary policies across countries? Should there be international rules not only with respect to capital controls, but with respect to reserve management, and monetary policy in general? Should countries be free to run the current account deficits or surpluses they want, or should there be restrictions on what they should do? Before the crisis, a number of emerging market countries had relied on low exchange rates and export-led growth. As these countries get larger and the competitiveness effect on other countries becomes more visible, does export-led growth remain an acceptable strategy for a multilateral point of view?

Safety net: In a different dimension, the great recession has showed that not only emerging countries, but also advanced countries, can suffer sudden stops. During the crisis, foreign liquidity was provided mostly through swap lines offered by the major central banks. Since then, the IMF has created two new liquidity windows. Is the problem solved, or is more needed?

These questions, and many more, will keep us busy for years to come. To take stock of the questions, and start exploring the answers, David Romer, Michael Spence, Joseph Stiglitz, and I have organized a conference on these issues. This conference will take place on March 7 and 8 at the IMF. While the conference is by invitation only due to space constraints, it will be webcast live. To follow it, and get more information please visit the conference website.

After the conference, we shall open a discussion site, and continue the discussion online. I hope many can join us and contribute as we continue to search for new approaches to the world’s changing macroeconomic and growth challenges.